By Hung Tran -- As assets under management dwindle and performance fees fall, hedge funds are increasingly looking for ways to cut costs. But choosing whether or not to outsource certain operations—especially those that have traditionally been done in-house, such as risk management—is a big decision. Managers must not only look at the potential cost savings, but must also consider the quality, reliability and security of their vendors. Despite the caveats, hedge funds are increasingly taking the leap.

“It used to be a black mark to have outside risk managers,” says Kenneth Grant, who has served as head of risk management for some of the world’s most prominent hedge funds, including SAC Capital Advisors, Tudor Investment Corp. and Cheyne Capital. In 2005, Grant set up his own shop, but he didn’t go the hedge fund route. Instead, he opted to focus on what he knows best—creating customized risk management reports for hedge funds.

His firm, Risk Resources, employs 20 people and works 24 hours a day analyzing everything from volatility and portfolio exposures to value at risk and scenario analysis. While Grant says there are many firms that provide some sort of risk management services software, it is the qualitative side of the analysis that is often lacking.

Hedge Fund Technology & Trading“Managers need someone to interpret all the data that they are given and tell them what it means,” he says. “It isn’t enough to just crunch the numbers.”

Jayesh Punater, founder of New York-based Gravitas Technology, which specializes in providing technology and software integration services to the alternative investment community, says he is seeing a surge in hedge fund firms choosing to outsource in order to save money and streamline operations.

“This is the era of hedge fund 3.0,” Punater says. “These hedge funds are smarter, rather than larger. They’re reducing overhead by using outsourced data centers and their focus has shifted from investing to running a real business.”

Punater says that pressure from investors and regulators is forcing hedge funds to expand their definition of risk, and hence, to find ways to manage it.

“No longer are firms just focused on P&L and trading risks; now they’re focusing on regulatory risks and the needs of investors,” he says. “What we’re seeing is increased demand for customized risk dashboards.”

Outsourcing the IT Guy

Another way hedge funds are reducing costs is by cutting personnel. Whereas funds once flush with cash could afford a full-time information technology staff, tough times call for tougher decisions.

“We recently saw a fund that was $6 billion before 2008,” says Alexander Kouperman, president of InfoHedge, a four-year-old technology firm. “We met with the CFO and the chief technology officer, and the CFO pointed a finger at the CTO and said, ‘This guy is my old friend and our wives are friends, but I have to fire him now because we don’t have the money to pay his salary.’”

Kouperman says his InfoHedge, which counts more than 90 hedge funds among its clients, is seeing a boom in demand, especially from firms that are being forced to downsize their operations due to decreasing assets under management.

“The outsourcing space is definitely in good shape, given what is currently happening in the market,” he says.

Warren Finkel, president of Network Doctor, which specializes in providing IT services to the financial community, says he, too, is seeing an increase in business from the hedge fund sector.

“We are seeing a strong move towards complete managed service offerings where IT consultants are being hired to handle all technology and not just relying on break/fix work,” Finkel says. “This allows the hedge fund owners to plan their spending and also allows them to focus their efforts on managing funds rather than worrying about day-to-day IT problems.”

He adds that another advantage of using an outside IT provider is that “a managed service provider can offer 24/7 support, monitoring and maintenance and provide technicians who are certified and proficient in each technology including networking, phones and computers. A managed service provider also has the knowledge of the technology options and possibilities since they provide support to multiple businesses and are able to bring this value to the fund.”

Protecting The Secret Sauce

But not all hedge fund executives are sold on the prospects of outsourcing everything but the trading to vendors. Brian Kim, founder of New York-based hedge fund Liquid Capital Management, says outside technology is a double-edged sword.

“If everybody was buying the same risk management platform, frankly, I don’t feel like it could be any good,” he says. “If [third-party vendors] were so good at managing risk, then they should be doing my job.”

Dmitri Sogoloff, founder of New York-based Horton Point, a quantitative hedge fund, echoes Kim’s sentiments. Sogoloff, whose uses InfoHedge’s technology, says while he’s satisfied with the vendor’s capabilities, there are just some functions that hedge funds should not outsource.

“We’re a technology-heavy shop and we have a lot of stuff that we develop in-house,” he said.

Indeed, despite the growing clamor for outsourcing solutions, Kim says vendors have more work to do. He has been searching for a way to ease the burden of labor-intensive back-office functions, but has found the solutions available wanting.

“Back-office and mid-office support is something I feel is a little lacking in the industry,” he said. “Everybody wants to sell you the latest trade management and execution platforms, but if I could get some more help in the back office, that would alleviate my burden from an administrative standpoint.”

The Nuts & Bolts: Servers, Hardware, Telephones & IT Experts

While some hedge funds—especially those dealing in high-frequency trading strategies like Horton Point—may be loath to use outside risk management systems, many of those same hedge funds prefer to employ third-party hardware vendors to manage servers, telephones, data recovery systems and the like.

In fact, Horton’s Point’s Sogoloff says he is comfortable with outsourcing the generic infrastructure that every hedge fund firm must have, such as computer hardware and backup services that provide business continuity in case of a disaster.

“We don’t need to spend the time or the money internally to do this,” he says.

New York-based technology provider Richard Fleischman Associates is benefiting from clients like Sogoloff—who in essence use a combination of in-house and outsourced technology. The firm boasts more than 400 hedge funds, private equity firms and broker/dealers as clients and is growing at a rapid clip.

"We probably do about 100 startups a year, and one of the things we've seen, post-Madoff, is a spread of outsource and in-source solutions, whether it's with equipment offsite or with in-house facilities,” firm founder and namesake Richard Fleischman said. “For folks starting new businesses, there is a lot of trepidation about building new offices, and they come to us for hosted solutions where they can get off the ground pretty quickly with minimum out-of-pocket expense."

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We are accustomed to splitting trading into technical and fundamental buckets. Both involve crunching data; one set includes market fundamentals and the other pure price data. Alternative data is a third bucket that is gaining traction.